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http://ssrn.com/abstract=641241
 
 

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The Roles of Expected Profitability, Tobin's Q and Cash Flow in Econometric Models of Company Investment


Stephen R. Bond


Nuffield College; Institute for Fiscal Studies (IFS)

Alexander Klemm


International Monetary Fund (IMF)

Rain Newton-Smith


Bank of England - Monetary Analysis

Murtaza Syed


Institute for Fiscal Studies (IFS)

Gertjan W. Vlieghe


Bank of England - Monetary Assessment and Strategy Division

June 2004

Bank of England Working Paper No. 222

Abstract:     
Evidence that cash flow has a significant effect on company investment spending, after controlling for Tobin's average Q, has often been interpreted as suggesting the importance of financing constraints. Recent work on measurement error in the Q model casts doubt on this interpretation. It is possible that the Q model may not be identified if there are 'bubbles' in stock market valuations that are both persistent over time and that are correlated with fundamental values. Cash flow may then provide additional information about expected profitability that is not captured by a poorly measured Tobin's average Q variable. We explore this hypothesis empirically using UK panel data on companies for which analysts' earnings forecasts are available from the IBES database. The results point to a severe measurement error in average Q. The paper finds that, controlling for expected profitability using analysts' earnings forecasts, cash flow becomes insignificant. Both sales growth and cash-stock variables do provide additional information, which could either be capturing expectations of profitability at longer horizons, or reflect misspecification of the basic Q model. Results for subsamples do not suggest financing constraints as a likely explanation for these findings.

Number of Pages in PDF File: 39

Keywords: Investment, panel data, financial frictions, Tobin's Q, share prices

JEL Classification: D21, E22, E44

working papers series





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Date posted: January 4, 2005  

Suggested Citation

Bond, Stephen R. and Klemm, Alexander and Newton-Smith, Rain and Syed, Murtaza and Vlieghe, Gertjan W., The Roles of Expected Profitability, Tobin's Q and Cash Flow in Econometric Models of Company Investment (June 2004). Bank of England Working Paper No. 222. Available at SSRN: http://ssrn.com/abstract=641241 or http://dx.doi.org/10.2139/ssrn.641241

Contact Information

Stephen R. Bond
Nuffield College ( email )
Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom
+44 1865 278 674 (Phone)
+44 1865 278 621 (Fax)
Institute for Fiscal Studies (IFS)
7 Ridgmount Street
London, WC1E 7AE
United Kingdom
+44 20 7291 4800 (Phone)
+44 20 7323 4780 (Fax)
Alexander Klemm
International Monetary Fund (IMF) ( email )
700 19th Street, N.W.
Washington, DC 20431
United States
Rain Newton-Smith
Bank of England - Monetary Analysis ( email )
Threadneedle Street
London EC2R 8AH
United Kingdom
Murtaza Syed
Institute for Fiscal Studies (IFS) ( email )
7 Ridgmount Street
London, WC1E 7AE
United Kingdom
Gertjan W. Vlieghe (Contact Author)
Bank of England - Monetary Assessment and Strategy Division ( email )
Threadneedle Street
London EC2R 8AH
United Kingdom
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